Friday, 17 October 2008

Need for Regulation

I read an interesting article this week that explained why there is a desperate need for external regulation of the market and why the market is not able to regulate itself.

The role of a bank is simple. To make profit for its shareholders. It has no obligation to its staff (they are a factor of production and a means to an end), or the wider community. It has one sole aim, to make a profit. This is basic free market economics. So, the bank sets about its business to do just that. And, if other banks around it are taking big risks, but in return making big profits, it will have no choice but to do the same. If it chooses to take a less risky position, it will make less profit that its rivals, its share price will fall and it will be liable to a take over. Again, this is basic free market stuff.

But thinking back a year to the sub prime mortgage market problems - it is pretty clear that the banks knew trouble was brewing. But in isolation, none of them could have taken a lower risk high liquidity position. Market forces and this focus on profit maximisation meant they were forced to take a high risk high profit position. No CEO could have sold a different strategy – let’s increase our liquidity for the next 12 months chaps because things might go wrong - but it might mean getting taken over and losing our jobs if i am wrong.

So, even if banks knew problems were pretty likely, this need to make a profit, or risk falling share prices and a take over, meant that they had to keep reducing liquidity to keep increasing profit.

What does this all mean - well, it means that the idea of a free market working in our best interests - or rather the idea that if we have banks et al maximizing profits, it will automatically be good for the community - is utter rubbish.

How can energy firms maximising their profits be good for the community?

There needs to be regulation - and we are seeing some of this coming into effect. World governments buying into banks and giving new rules for how they are governed. In the UK we have seen government intervention to force energy and petrol prices down (would the market without pressure from our government have led to prices for unleaded falling below £1. I don't think so. Prices are always slow to come down and it took some pretty assert behind the scenes pressure to force them down.

Again, the markets are not able to work in our best interests.

So, we are seeing across the globe a move to more government regulation. And this is surely welcomed. And i hope that it leads to a more equitable economy. We will see.